File C5-209
May 2008
www.extension.iastate.edu/agdm
Managerial Costs
W
hen accountants prepare financial statements of past performance, they use a
variety of categories for recording costs.
Categories such as advertising cost, administrative
costs, labor costs and many others are used that help
identify the type of cost.
However, using costs for decision-making is much
different. For this purpose, costs are categorized into
two basic types. They are classified as either variable
or fixed.
A cost is variable or fixed depending on whether the
amount of the cost changes as the volume of production changes. A cost is a variable cost if it increases
(decreases) as the volume or production levels increase (decrease.) For example, the amount of a raw
material used in the production process increases as
more units of a product are produced (more corn is
used to make more ethanol.)
Fixed costs do not change with changes in production. Fixed costs remain the same regardless of the
amount of production. For example, the depreciation on an ethanol facility is the same regardless
of whether the facility is operated at 75 percent of
capacity or 100 percent of capacity.
So, for decision-making purposes, costs are categorized as either fixed or variable.
sum of all of the costs that vary in direct proportion
to production.
Semi-variable Costs
Semi-variable costs are costs that have both a variable and fixed component. Commercial leases often
have a fixed rent per month plus an additional rent
based on the amount of production or sales. For example, rent is $5,000 plus five cents for each pencil
that is made. The base rent of $5,000 is a fixed cost
and the five cents per pencil is a variable cost.
Step-variable Costs
Step-variable costs are costs that are constant over
a range of production. If one employee can make
10,000 pencils, then the employee’s wage is constant
over a production range of one to 10,000 pencils. If
you produce 11,000 pencils, you will need another
employee. So your cost doubles. If you make 25,000
pencils your cost triples because you need three
employees.
Figure 1.
Step Variable Costs
Total
Variable
Cost
Variable Costs
Variable costs are those costs that vary directly with
the amount of production. For example, if you are
a pencil maker, you need an eraser for each pencil
you make. So erasers are a variable cost of making
pencils. If you make 1,000 pencils you need 1,000
erasers. If you make 5,000 pencils you need 5,000
erasers. If erasers cost 20 cents each, the variable
eraser cost of making 1,000 pencils is $200 (1,000
X $.20). If you make 2,000 pencils, the variable cost
is $400 (2,000 X $.20.) Total variable costs are the
Production
However, this cost can be converted to a true variable cost by paying employees a fixed amount for
each pencil they make, instead of a fixed wage. For
example, if the employee is paid 10 cents for each
pencil he/she makes, the labor cost is now a true
variable cost.
Don Hofstrand
extension value-added agriculture specialist
co-director Ag Marketing Resource Center
641-423-0844, dhof@iastate.edu
File C5-209
Page 2
Fixed Costs
Avoidable Fixed Costs
Fixed costs are those costs that don’t change regardless of the amount produced. If our pencil maker
hires a bookkeeper for $10,000, this is a fixed cost
because the cost stays the same regardless of the
number of pencils that are produced. Fixed cost may
only be relevant over a range of production. For
example, if a processing facility capacity is 100,000
units of production, 100,000 is the upper limit of the
range for the fixed cost. Production over 100,000
will require additional facility investments which
will mean more fixed costs.
Avoidable fixed costs are costs you are not required
to incur. In other words, you will stay in business if
you don’t incur the cost. If the pencil maker spends
$5,000 on advertising his/her pencils, this is a fixed
cost. However, it is avoidable because he/she can
stop buying advertising and still stay in business
(although sales volume may suffer).
Example 1.
Using the pencil maker example above, the
variable and fixed costs are show below.
Unavoidable Fixed Costs
Unavoidable fixed costs are costs you have to incur
if you want to stay in business. For example, the
administrative costs of running a processing facility
are an unavoidable fixed cost. Interest on term debt
on the facility is also an unavoidable fixed cost.
Sunk Costs
Variable cost per pencil
Erasers
$.20
Rent
.05
Labor
.10
Total
$.35
Fixed cost
Rent
Labor
Total
$5,000
10,000
$15,000
Total cost can be computed using this formula.
Total Cost = (Variable Cost X Units Produced) +
Fixed Costs
If 10,000 pencils are made, total cost is $18,500
Total Cost = ($.35 x 10,000) + $15,000
Total Cost = $3,500 + $15,000
Total Cost = 18,500
If 100,000 pencils are made, total cost is
$50,000
Total Cost = ($.35 X 100,000) + $15,000
Total Cost = $35,000 + $15,000
Total Cost = $50,000
Sunk costs are costs that have been paid. A variable
cost that is paid becomes a form of fixed cost called
a sunk cost. Because the cost has already been
paid, it is a fixed cost. Avoidable fixed costs become
unavoidable fixed costs once the cost has been paid.
Likewise, a variable cost becomes a sunk cost once
it has been paid as shown in the figure below. For
example, purchasing $2,000 worth of erasers to use
in making pencils (above) is a sunk cost. So, as you
progress through the production period, costs that
were initially variable become fixed. Once the pencils are produced and entered into inventory, most
of the variable costs have been incurred and become
sunk or fixed costs.
Figure 2.
Total Costs
$ Costs
Variable
Fixed
Time
(production period)
Page 3
File C5-209
Decision Making
Another example is shown below.
The net return or profit from the pencil example can
be computed by using variable and fixed costs.
Example 3.
Example 2.
Assume
Pencil price = $1.00
Pencil sales = 50,000
Variable cost = $.35 x 50,000 = $17,500
Fixed cost = 15,000
Total cost = $32,500
Revenue = $1.00 x 50,000 = $50,000
Assume
Pencil price = $.75
Pencil sales = 25,000
Variable cost = $.35 x 25,000 = $8,750
Fixed cost = $15,000
Total cost = $23,750
Revenue = $.75 x 25,000 = $18,750
Net return = ($5,000)
Net return = $17,500
. . . and justice for all
The U.S. Department of Agriculture (USDA) prohibits discrimination
in all its programs and activities on the basis of race, color, national
origin, gender, religion, age, disability, political beliefs, sexual orientation, and marital or family status. (Not all prohibited bases apply to
all programs.) Many materials can be made available in alternative
formats for ADA clients. To file a complaint of discrimination, write
USDA, Office of Civil Rights, Room 326-W, Whitten Building, 14th
and Independence Avenue, SW, Washington, DC 20250-9410 or call
202-720-5964.
Issued in furtherance of Cooperative Extension work, Acts of May 8
and June 30, 1914, in cooperation with the U.S. Department of Agriculture. Jack M. Payne, director, Cooperative Extension Service, Iowa
State University of Science and Technology, Ames, Iowa.